We are economists writing about economics: Karl Smith, an assistant professor of economics and government at the School of Government at the University of North Carolina; and Adam Ozimek, an associate at an economics consulting firm. As most in our profession are eager to tell you, economics includes just about everything, so we'll be blogging -- with varying degrees of success -- about the economy, markets, politics, science, technology, philosophy and culture. We both come from a similarly vague libertarian ideological perspective, but we've been called neoliberal as well, and idiosyncratic might be the best adjective to use.

How The Price of Oil and Gasoline Could Crash

I like to keep an eye out for scenarios that may be unlikely, but if they unfold will come on fast and without the types of warning signs that people expect. Here is one:

Steel prices are already moving downward. Slower growth out of the developing world continues to support that trend. Slower developing world growth will also drive down margins for heavy equipment manufacturers like CaterpillarCaterpillar.

Increasing interest rates are slowing the housing recovery and lessen the demand for construction workers. This current rate rise is a bit of a conundrum, but for now lets assume that it makes sense and is not simply based on the market misreading the Fed’s intentions or the Fed itself being stuck in some sort of odd policy trap.

This gives us a scenario where steel, earthmovers and construction workers are all relatively cheap. That implies that building pipeline infrastructure would be relatively cheap.

As it stands oil and natural gas already sell for very different prices in North America because of distribution constraints. Moreover, distribution is most constrained in the newer, more capital intensive and prices sensitive supply areas. I don’t know the current spreads off my head but here are few of the stylized bottlenecks I am thinking of: Oil in the Texas’s Permian basin is selling at a significant discount not only to Brent but (ironically) to West Texas Intermediate (WTI). This is because of difficulties getting the oil to Cushing. And, of course famously there are bottlenecks in getting the oil out of Cushing and to the Houston-Lafayette refining corridor. However, the oil coming out of the Permian right now is produced using relatively mild “unconventional” techniques. As of yet, there is little fracking going on there even though the geology seems promising. The clear reason is that price for oil out of the Permian won’t support fracking until distribution bottlenecks are cleared.

In Eagle Ford we have a lot of low API petroleum sources, what I am going to call natural gasoline, but has many names including extra-light crude. This stuff is from a chemical standpoint quite valuable – for a number of reasons – but has been and still maybe selling at a discount to WTI because currenty the most profitable way to handle it is to pipe it to Houston, where most of the refining infrastructure is set up to extract the maximum value from very heavy crudes. If you use that refining capacity for natural gasoline not only are you wasting much of the complexes power but you are not getting the side products the complex is designed to extract. So, to the refiner this stuff is actually less valuable then lower grade crudes.

In Pennsylvania, we have natural gas deposits that seem extremely rich not only in natural gas but in ethane, which is chemically more valuable than natural gas. Once again, however, distribution bottlenecks mean that the ethane rich natural gas cannot get to where it can be effectively refined and without being refined the ethane rich natural gas is actually less valuable because its too potent to be sold as municipal natural gas.

Lastly, the Tar Sands in Canada could produce an enormous amount of petroleum, but its so thick that moving it to a refinery is a major problem.

To start to put it all together. The Canada oil could be piped to Houston if it could be diluted by natural gasoline. Eagle Ford natural gasoline would then be very valuable if it could be piped to Canada and then the mix piped to Houston. This would increase the profitability to fracking new supplies in Eagle Ford and continuing to ramp up Canadian production. That encourages evermore North American production, which would displace imports and push down the world price of petroleum and gasoline.

In a similar vein, piping the ethane rich natural gas out of Pennsylvania to the Natural Gas processing complex in Mount Belvieu (MB) would do several things. First, it would increase the profitability to fracking in the Marcelus Shale, which would increase North American production – of nat gas I know but hang with me. This produces even more ethane that will be relatively cheap in MB. This means first that it will be unprofitable to crack propane or butane for petrochemical purposes. That means more butane can go to Houston as an input to refined motor gasoline and more propane can go abroad where it is used as a gasoline substitute. Second, cheap ethane in MB means that BASFBASF will be induced to move petrochemical production out of Europe and to Texas.

In Europe, however, the feedstock for petrochemicals is Naptha – which is essentially refiner produced natural gasoline. We could call it unnatural gasoline and indeed Naptha is raw gasoline before it has the appropriate mix off additives thrown in. Less petrochemical production in Europe means less demand for Naptha which means more supply of gasoline.

What this means is that an intensively beefed up pipeline infrastructure in North America would allow new resources to be refined more efficiently. That means greater prices for producers, which will induce them to increase production. That increase in production means less demand for foreign oil, which means lower global prices for oil and importantly gasoline.

And, right now the raw materials to create that infrastructure: steel, earthmovers, and construction workers is relatively cheap. Thus it is plausible that we could see many more pipelines being built and built more quickly. The supply of North America oil and gas would increase, and the world price would fall.

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